Without a functioning international permit market

When the international market for permits is either not functioning at all, or is so thin that permits cannot be reliably bought or sold internationally, the functioning of a domestic permit system is more like the traditional case in which quantity is constrained. In this section, we consider the scenario in which the international market is entirely non-existent. However, the actual scenario that evolves is likely to be less black and white.

Without an international market, New Zealand’s marginal benefit curve consists of three components: the marginal domestic environmental benefit, international favour gained for compliance, and any indirect effect New Zealand’s abatement has on the likelihood of cooperation with Kyoto by other countries.

The marginal environmental benefit includes only that benefit gained by New Zealand from its own abatement. Other countries also benefit from New Zealand’s abatement, and in this sense the country can be viewed as a private producer of a public good. As such, our abatement would be worth much more internationally that just its value to New Zealand. Consequently, the marginal domestic environmental benefit will be much lower than the international permit price would be if an international market existed. It may, in fact, be so low as to be negligible. Because New Zealand emissions are such a small proportion of worldwide emissions, marginal environmental benefits for New Zealand are flat across all levels of domestic abatement.[7]

The second component of the marginal benefit curve is international favour that New Zealand would gain if it were to comply with its domestic target in the absence of international emissions trading. This marginal benefit is likely to be positive at low levels of abatement, but can be expected to fall off quickly above compliance-level abatement. It is possible that this marginal benefit may be discontinuous, or at least not smooth, at New Zealand’s target abatement level.

If the marginal costs of abatement turn out to be very high, New Zealand may choose not to comply with its Kyoto target. This is more likely in the absence of an international market than when one exists, because a shock that causes domestic abatement costs to be unexpectedly high is more likely than one that causes worldwide abatement costs to be unexpectedly high. As in the case with an international market, New Zealand will receive less international pressure to comply if many other countries have chosen not to.

The final component of New Zealand’s marginal benefit curve is the effect New Zealand’s abatement has on the cooperation and therefore abatement of other countries. New Zealand’s efforts towards abatement are likely to encourage other countries towards compliance with Kyoto, and we will reap the environmental benefits of their resulting increases in abatement.

The value of these environmental benefits to New Zealand depends partly on the effect of climate changes on New Zealand society. The effects on New Zealand society of a certain level of climate change depend on a variety of factors such as the future level of our reliance on agriculture (which may suffer significantly under climate change), the extent to which the population will be living by the coast (in danger of rising ocean levels), and how rich, and therefore able to deal with the change, the country will be.

Figure 4 – Marginal cost and marginal benefit without an international permit market

Figure 4 above illustrates one possible appearance of the marginal cost and marginal benefit curves in the absence of an international permit market. MC is marginal costs; MB is marginal benefits. The MC curve is drawn here as being flat and virtually zero at low levels of abatement, then curving up sharply beyond some threshold level of abatement. This is not an unreasonable shape because there is evidence to suggest that New Zealand will be in compliance with Kyoto in the first commitment period even without any policy influence. However, in the short run, if New Zealand tried to reduce emissions significantly, marginal costs might rise steeply.

In the absence of an international market, Weitzman’s analysis applies to domestic abatement, and the preferred instrument depends on the relative slopes of the two curves around their point of intersection. If the marginal benefit curve is steeper, a permit system will yield lower expected losses; if the marginal cost curve is steeper, a tax system will yield lower expected losses.

However, one of the main uncertainties about the marginal cost and benefit curves is the point at which the marginal cost curve begins to rise. As illustrated above, the curves could intersect where the marginal benefit curve is flat. In this case a tax may be optimal. However, if the point where marginal costs become significant is at a lower abatement level, marginal benefit might be very steeply sloped at the point of intersection. This would make a permit market more attractive.